Introduction
The trends in project management and operations have shifted in the country. In the late 90s, large projects were typically valued at around INR 500 crores+. Today, mega projects are to the tune of INR 1 lakh crore and above. One could argue that a lot of inflationary factors are involved in the valuation of these projects. That is, however, only partially true. What is more important is that the fundamentals of economics are being applied to the projects. This is not particularly good news for the country, although the trend to look at larger projects is, often times, viewed as a status symbol to most professionals. Let us understand this dynamics really well.
Key Basic Project Management Concepts
At the core of project management is the initiation process. That is the conceptualization of projects and the application of tools and techniques to evaluate the feasibility. So, what does the feasibility study do? As explained in my book, A Forward Looking Approach to Project Management: Tools, Techniques and the Impact of Destructive Technologies, the feasibility study is described as follows:
It is a business need that translates into project activity. And most times, the project has a longer lasting effect than the operations, which implies that the business need creates an asset, in financial accounting terms, at the end of the project.
The understanding of a project in a business environment, therefore, requires an understanding of both the business as well as the project environment. Such a study is called the Project Feasibility Study.
The study of how the asset impacts business is typically done using some financial concept like the Discounted Cash Flow Methods. Apparently, these methods are found to be robust, but they fail to evaluate subtle aspects that are embedded in the feasibility analysis.
For the sake of a demonstration, we would now use the Internal Rate of Return method. Again, a quick description given in the book is as follows:
The IRR is defined as the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project.
Let us now understand how this parameters pan out in typical project environments.
Some Advanced Project Management Concepts
Project management theory often speaks of situations where there are over-runs, that is the projects actually go above and beyond their budgeted time and costs. In fact, in Chapter 9 of my book, I have explained the perspectives involved in understanding the impact of time and cost overruns. And with an example, the model has been laid out and the unanimous winner is the cost overrun. In other words, in the race between time and cost, the cost is supposed to have a greater influence on the overall IRR. This is common knowledge and most project managers would readily agree with the fact that getting a budget modification is far more difficult than a time extension (usually, the time extension is an organic phenomenon).
As a seasoned professional, however, these two are supposed to be phenomenon characterizing poor project skills. These could be at the strategic or the operational level or both. Irrespective of how one views it, the fact is that these phenomenon are well documented and understood in modern projects. In fact, a lot of literature is readily available at the disposal of the professional, to tell him/her as to how one has to navigate through the situation.
But this article is on yet another phenomenon. That is the overestimation in the project costs. Overestimation occurs for multiple reasons like:
- Inherent inefficiency in execution
- Buffer for uncertainties
- Possibility of the top management to sanction only partial amounts
- Historical inefficiencies that get carried forward
- In-appropriate data analytics models
- Poor implementation teams that are ‘static’ strategic partners, etc.
The concept of overestimation is what we would delve on now. So, most project proposals contain estimates that have intrinsic higher values or are ‘padded’ in project management parlance.
At the same time, the operations often leverage scale more explicitly. For instance, doubling capacities don’t necessarily mean doubling of resources. In fact, in most times, one can safely assume that the doubling of capacities translate to some advantage in the operational cash flows. This is also called the economy of scale. The usual operational trend is that it increases marginally with the scale, and most times, this isn’t a linear relationship. It is often seen that there is a hidden capacity in the operational infrastructure that can absorb a lot of the increased demands. Thus, it often follows a step function.
The Phenomenon
Now let us consider a simple case to explain how the inefficiencies operate in a project environment. We take the case of the following cash flows (all figures are in USD million):
| Project Cost (in USD Million) | -48 |
| Cash Flow Year 1 | 10 |
| Cash Flow Year 2 | 20 |
| Cash Flow Year 3 | 20 |
| Cash Flow Year 4 | 25 |
| Cash Flow Year 5 | 15 |
| Internal Rate of Return (IRR) | 23.31% |
Clearly, one sees that this is a very lucrative project with a reasonable IRR that is much higher than the current lending rates. However, this base cash flow now needs to be analyzed further. If the project isn’t executed efficiently, what happens? Let us assume that the inefficiency is to the tune of 25% in this case. That simply means that the project cost is now jacked up and stands at 60 million USD. The cash flow, therefore, is seen as follows (all figures are in USD million):
| Project Cost (in USD Million) | -60 |
| Cash Flow Year 1 | 10 |
| Cash Flow Year 2 | 20 |
| Cash Flow Year 3 | 20 |
| Cash Flow Year 4 | 25 |
| Cash Flow Year 5 | 15 |
| Internal Rate of Return (IRR) | 14.16% |
The increase in the costs due to project management inefficiency by 25% has reduced the IRR by around 40%. Suddenly, the project doesn’t look as lucrative as before. This is the first concept that we discussed, whereby the project with inefficient management concepts actually costs the organization due to the IRR.
Now let us assume that one is doubling the project size. However, in this doubled budgetary outlay, let us assume that operational economy of scale brings in a benefit of 4%. That means a cash flow of 10 million USD, in the new scenario would generate 10 * 2 * 1.04 or 20.8 million USD. So, this added cash flow is going to work towards our advantage. We now see how the cash flows look like in the new scenario:
| Project Cost (in USD Million) | -120 |
| Cash Flow Year 1 | 20.8 |
| Cash Flow Year 2 | 41.6 |
| Cash Flow Year 3 | 41.6 |
| Cash Flow Year 4 | 52 |
| Cash Flow Year 5 | 31.2 |
| Internal Rate of Return (IRR) | 15.69% |
Suddenly, one sees a jump in about 1.5% in the overall IRR. So, a 4% benefit due to the economies of scale has given us an increase in the IRR value by around 11% (i.e., 15.69/14.16*100)!
On the other hand, if one were to actually have an improvement in project execution, the inefficiencies would reduce. If we assume a 4% reduction in the overall costs of the project, even without the operational inefficiencies, one sees an improvement in the IRR as follows:
| Project Cost (in USD Million) | -115.2 |
| Cash Flow Year 1 | 20 |
| Cash Flow Year 2 | 40 |
| Cash Flow Year 3 | 40 |
| Cash Flow Year 4 | 50 |
| Cash Flow Year 5 | 30 |
| Internal Rate of Return (IRR) | 15.76% |
Thus, a reduction in project inefficiencies is more beneficial than a gain in the economies of scale. This is a very important take away.
However, if one works on both the fronts, then one sees a significant jump in the IRR numbers. That is to say, a reduction in project inefficiencies and an improvement in the operational economies of scale, the project actually starts becoming far too lucrative.
| Project Cost (in USD Million) | -115.2 |
| Cash Flow Year 1 | 20.8 |
| Cash Flow Year 2 | 41.6 |
| Cash Flow Year 3 | 41.6 |
| Cash Flow Year 4 | 52 |
| Cash Flow Year 5 | 31.2 |
| Internal Rate of Return (IRR) | 17.32% |
Whats the takeaway?
The key takeaway for the project manager is to understand that project inefficiencies and operational economies of scale have countering effects. That is more the inefficiency, lower the IRR. More the operational economies of scale, higher the IRR.
Most organizations harp on their experience to execute projects well. However, these organizations are often approaching a ‘glass ceiling’ of some sorts when it comes to efficiencies. Therefore, the trend has been to look the other way… That is, most times companies work on large projects to leverage the operational economies of scale. However, this doesn’t mean that the project is well executed. On the contrary, the operational economies of scale make pursuits of project cost optimization less relevant (to be honest, lesser in the limelight). Companies with large capital outlays, like oil companies and telecom companies in India, and others (not naming any here but they are well known), etc. have gone a step further in increasing the leverage from the operational economies of scale. That doesn’t necessarily mean that the projects are better managed. However, larger projects tend to show better IRR figures, but are often times misleading when it comes to their own management.
A direct fall out is to make managers aware that efficient project management methods help in maintaining a good IRR. Its time to revisit the project management practices and ensure good results. There are separate tools for evaluating this correlation better. This article is just an overview of one of the basic concepts in project feasibility studies that covers estimation as an element of interest.
More importantly, the tendency of covering up project inefficiencies must be discouraged. Project environments often get plagued by political currents, leading to far lower inefficiencies and a ‘pass-the-buck’ phenomenon to the operations (by way of the economies of scale). However, this leads to huge losses and typical projects could see a significant way to reduce such unwanted ‘wastages’ that don’t necessarily hit the numbers, but definitely hit the culture and the futuristic economic scenario that is being created.